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A lawsuit, filed on May 8, 2013, and unsealed this week in New York claims that Vanguard has used its SEC exemptive order, allowing it to operate “at cost” to avoid paying “approximately $1 billion of U.S. federal income tax and at least $20 million of New York tax over the last ten years.” Secondary to the “at costs” arguments, the suit also alleges that Vanguard didn’t treat a $1.5 billion Contingency Reserve properly from a tax perspective.

Filed by a former Associate Counsel and tax attorney who worked for Vanguard for just under five years, the suit makes some pretty major allegations.

Let’s start by saying I’m not a tax attorney. I can’t debate the merits of the lawsuit or some of the allegations presented in it. But from a broader perspective, this assault on Vanguard’s “at cost” operating principle could, if successfully challenged, have seismic implications for the fund industry and possibly put competitors on a more level playing field with Vanguard as far as costs are concerned.

How so? Well, let’s look at one example. According to the complaint, Vanguard prices its services to its overseas funds as “a 7.5% cost-plus return.” To give a sense of how this might translate to higher costs at home, consider the Vanguard U.S. 500 Stock Index Fundoffered to overseas investors. The fund’s investor share class charges a 0.25% operating expense compared to the investor class expense of 0.17% for Vanguard 500 Index Fund (VFINX) here at home. That’s still low, but it’s almost 50% higher than what U.S. investors pay. Vanguard’s ETF shares currently charge just 0.05% in expenses. Add on a basis point or two, and while it’s still low, the expense ratio would be closer to the iShares Core S&P 500 ETF‘s (IVV) 0.07% or SPDR S&P 500 ETF‘s (SPY) current 0.0945%.

On the managed front, the differences are even more stark. The Vanguard U.S. Opportunities Fund is managed in essentially the same style as the Vanguard PRIMECAP (VPMCX) or Vanguard Capital Opportunity (VHCOX) funds here in the U.S. The all-in expenses for the overseas fund are 0.95% for the investor shares. Investor-share expenses for PRIMECAP and Capital Opportunity are, respectively, 0.45% and 0.48%. Obviously, there’s no way of knowing whether the differences in these expense ratios is related to actual costs, and how much is related to the alleged “7.5% cost-plus” contractual obligation. But there are differences.

I believe the crux of the whole complaint as far as its potential impact on the industry lies in the allegation that “Vanguard’s costs are, however, generally quite consistent with its competitors’ costs, with the notable exception of Vanguard’s tax costs.”

The fund industry’s competitive landscape could change dramatically if Vanguard is forced at some point to raises fees to address costs it has heretofore avoided — consciously or not. Particularly in the ETF space, a matter of basis-point differences between funds with identical benchmarks matters a lot; the attack on Vanguard’s “at cost” expense regime is a serious one and must have competitors in a frenzy debating its merits and potential impact.

All in, whether this lawsuit has merit or not, and whether Vanguard is forced to raise expenses for costs they haven’t always accounted for, I believe the company will remain one of the low-cost leaders in the industry. However, a ruling against the complex would be a huge hit to the firm’s reputation as an investor advocate and ethical leader. The story continues…